Bank Disintermediation

Topics: Economics, Bank, Debt Pages: 6 (1613 words) Published: May 21, 2011
The factors that have been responsible for bank disintermediation

In my opinion, there are three major arguments for the factors that have been responsible for bank disintermediation. First, pareto improvement (Vilfredo Pareto), second, reputation acquisition in debt markets (Diamond, D., 1989), third, corporate finance theory (MM & Trade-off Theory). 1. Pareto Improvement (Vilfredo Pareto)

According to Pareto efficient (Vilfredo Pareto), if economic allocation in any system is not Pareto efficient, there is potential for a Pareto improvement—an increase in Pareto efficiency: through reallocation, improvements to at least one participant's well-being can be made without reducing any other participant's well-being When the Pareto efficient is applied to whole financial market, it means the financial resource distribution will achieve ‘Pareto Improvement’. Under me economic conditions, financial market do not hinder the development of the real economy by itself and financial market can raise economy to run efficiency through own reform. In this situation, the financial resource distribution will achieve Pareto Improvement. The development of financial market wants to achieve Pareto Improvement of the financial resource distribution. This objectively changed the pattern that commercial bank is one side alone in the financial market. Because the directly financing is emerged, the financial resource distributions have achieved Pareto Improvement. 2. Reputation Acquisition in Debt Markets (Diamond, D. , 1989) The traditional theory of financial intermediaries, such as commercial bank, considered that it can reduce transaction costs by economies of scale. Meanwhile, financial intermediaries also can effective avoid adverse selection and moral hazard because of the information asymmetry of the supply and demand sides. Thus, money providers do not directly provide money to the money demanders, but by using financial intermediaries to do this process: Money demanders

Financial intermediaries
Money providers

Table 1
There are three seasons for this process: First, high investigation costs, when money providers want to find the borrower in the market, they must investigate many information for borrowers, such as, the business condition, credit and so on. This investigation will increase costs. Second, screen analysis costs. Money providers wanted to know the demanders’ investment project in order to contrast the rate of return between the investment project and average market borrowing rate. Third, monitor cost. Money demanders may tell a lie about earnings to reduce the interest payment, so money providers must pay monitor cost in order to avoid this situation. In a word, Money providers want to directly provide money to money demanders must pay these three costs. Sometimes these three costs are more than profit (return form money demanders), so it was uneconomic that the supply and demand sides solve problems of money directly. According to Reputation Acquisition in Debt Markets (Diamond, D., 1989), the accumulation of reputation can solve the three costs problems. The process of accumulation is: at the first, all enterprises apply for loan form bank and bank will select qualified enterprises to provide money. Then enterprise will return the loan and interest by bank supervision. With good development of business partnership, enterprises get the good profit and pay back loan to bank immediately. The reputation is slowly becoming, and the information of enterprise will become public information which is too cheap. So improving the reputation solves the high investigation costs problem. Enterprise’s good profit can solve the screen analysis costs problem. Monitor cost be solved by enterprise long-term accumulated reputation. Thus there are no obstacle between enterprise and direct money providers. They are independent of bank 3. Corporate finance theory (MM & Trade-off Theory)

According to MM Theory...

References: Pareto efficiency from Wikipedia, the free encyclopedia
Diamond, D. (1989), "Reputation Acquisition in Debt Markets," Journal of Political Economy, 97(4): 828 862
Donald E. Campbell and Jerry S. Kelly (1994) "The American Economic Review," American Economic Association, 1994
David Hillier, Stephen Ross, Randolph Westerfield, Jeffrey Jaffe, and Bradford Jordan (2010) Corporate Finance. European edn. McGraw-Hill
Walmsley, J, New Financial Instruments, Wiley, 2nd Edition, 1998, Chapter 8.
Profits and Balance Sheet Developments at U.S. Commercial Banks Federal Reserve Bulletin, 1985-2005
Flow of Funds Accounts of the United States, Board of Governors of the Federal Reserve System, Washington D.C. 2055. B.102 Balance Sheet of Nonfarm Nonfinancial Corporate Business, P100
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